“The irrationality of a thing is no argument against its existence, rather a condition of it.” Friedrich Nietzsche
In this second quarter of the year, the pace of geopolitical events continued at a frantic pace requiring investors to constantly retool their views and risk management frameworks. However, given that the SP500 index sits within a whisker of its previous highs and the yield on the 10-year US Treasuries is approximately only 20 basis points lower than it was at the beginning of the year, Shakespeare would say: “Much ado about nothing.”
Indeed, since the beginning of the year, volatility and uncertainty have been high but ultimately, financial markets have shown resilience and especially retail investors have proven right by once again buying the dip.
What might explain such resilience is a confluence of factors. Corporate profits and especially corporate guidance remained solid, the labor market slowed down but it did not crack, and inflation numbers have so far remained controlled albeit above optimal levels. As far as the bullish behavior of retail investors, it may be that saving and investing actions are now so entrenched in retirement dynamics that it would take much more significant dislocations to flip the “sell switch.”
Additionally, as we indicated in one of our recent video blogs, the positioning of institutional investors, who were net sellers during the correction, is now underinvested and it is probably forcing them to play catch-up with the indexes.
However, looking ahead it is not all blue skies. The odds of a recession are still high. For instance, JP Morgan is still setting such probabilities at 40%, a non-trivial risk. The general level of US tariffs is currently much higher than in the last few decades and it is currently set at 17.5%. It is unlikely that any substantive deal will be reached by July 8th, the deadline announced by this administration to complete satisfactory deals or to reinstate the draconian tariffs revealed on “Liberation Day.” It is also unlikely that such draconian fees will be put in place again even in the face of a lack of signed deals, but it is reasonable to expect that on average tariffs will remain much higher. At the current level, tariffs are calculated to be approximately a $400 billion tax on importers and US customers. And then there is the issue of expanding public deficits which is forcing larger issuances of Treasuries, an action that prevents yields on the long end of the curve from coming down more aggressively. Significant public deficits also contribute to add pressure to the US Dollar and to the reversal of American exceptionalism. Foreign investors currently hold $57 trillion in US financial assets, up from only $2 trillion at the end of the 1990s. This total includes, among other assets, $16.5 trillion in equities, $14.5 trillion in debt securities and, $16.5 trillion in Foreign Direct Investments. While there aren’t great alternatives in debt securities, international demand will continue to slow down as reserve accumulation is reduced, and many countries will increase to implement reserve diversification away from the US Dollar. As for equity allocations, international money managers will certainly keep an eye on the resilience of trends such as US based AI, but they will be wary to add to already significant positions when valuations are not very attractive.
This complex and interlinked macro background seems to indicate that financial markets will be somewhat locked for the foreseeable future. Long-term allocations will still require balanced portfolios with healthy exposure to intermediate duration bonds and an increase in exposure to international equities.
As always, we would like to thank you for your renewed confidence in our work,
Youri Bujko
Davide Accomazzo